Italy is facing increasing market pressures at the moment that could transform, if prolonged, its liquidity crisis into a solvency crisis. Amid this increasingly bleak environment most analysts agree that the European Central Bank should step in and act as a lender of last resort by monetizing debts. I myself have long been in favor of the ECB acting as a real central bank that above all protects the currency it issues. Though this would be beneficial for the eurozone at the moment, I realize there are a series of obstacles that prevent the ECB from taking action. Those are moral hazard, potential inflation and the politics involved. I did not include any legal barriers, since the EU Treaty articles do not prevent the ECB from monetizing debts – debt monetization can be done via interventions in the secondary markets, without violating the “no-bailout” clause.
Moral hazard is in my view among the primary concerns of policy-makers. They fear that once they allow the ECB to monetize debts, there will be no end to the cost since whenever there is a precedent other countries wish to take advantage of it and will be well justified to do so while at the same time the credibility of the ECB as the most independent central bank in the world will be lost, whatever consequences this might have on the behavior of investors. Within the context of the eurozone, where debt monetization would be a politically favorable path for many politicians in power in quite a few countries, the fear of moral hazard increases. Yet I think that European leaders are very late to worry about moral hazard in this particular scenario, when massive bailouts have already been given to banks and states, while also, the 50% haircut on private investors holding Greek debt has been labeled as “voluntary”, effectively eroding the confidence markets had in the checks and balances provided by the CDS.
A potential rise in inflation is also worrying policy-makers. They believe that the necessary scale of debt monetization, will in fact create oceans of euro, without any real increase in actual products, eventually leading to a rise in prices. Given that euro area annual inflation is estimated by Eurostat at 3%. Many in Europe, especially in the core European countries, Germany first, get chills to the bones when they hear about higher inflation. On the other hand many analysts, argue that in the midst of a recession, the expansion of the money supply does not lead to inflation and even if it did, a mildly higher inflation over an extended time horizon would actually eat in the aggregate debt, effectively reducing debt burdens. Here is what I wrote on the matter in a previous article, titled “Only the ECB can be a bazooka in Europe – EFSF is a tower of cards”:
In practice the drafters of the euro had erected a Maginot Line against inflation by creating a very conservative central bank, which current policy-makers do not even consider of revising (see Stricter rules are good – Stabilizing Mechanisms are much better). Our leaders are trapped in the fallacy of following the exact same dogma the drafters of the euro had, by producing measures to address inflationary pressures. This would have been very effective had the issue been one of inflation. The point here is that what we are dealing with and what our leaders fail to grasp is a series of existential pressures, not inflationary ones. Market pressures are mounting due to the lack of confidence in the euro architecture itself to overcome its own rigidities and institutional gaps. Inflation is secondary in importance when the very existence of the euro is challenged. It makes no difference at all to reinforce the Maginot Line, since the weak spot is elsewhere. That is the lack of a final backstop in Europe, a role only the ECB can effectively fulfill.</p>
Apart from the economic concerns, one cannot possibly omit the political dimension of the matter. Political bargaining is of cardinal importance to the way the crisis evolves and European leaders react to it. The continuation of the crisis, is a means through which deep reforms that were postponed for decades can finally take place at once, under the threat of bankruptcy. Below are the four main political dynamics that prevent the ECB from acting as a final backstop (from my article The current economic and political situation in the Euro Area):
The political situation:</p>
- Regardless of how cynical this might sound, the crisis is seen as a unique opportunity to push for the most radical reforms in countries that have been unwilling to implement the necessary changes over the last years/decades (the shock therapy approach). In practical terms, the immense pressures that arise from the prospect of default in Greece first and then in Portugal, Ireland, Italy and Spain give the power to the rest of the eurozone countries to use their economic support to demand much needed reforms.
- Germany, Netherlands, Austria and Finland possess immense bargaining power over the rest of the countries, because of their much more favorable economic position. On the other hand countries like Italy and Spain, despite the fact that they are the 3rd and 4th largest economies of the euro do not even dare to think of speaking their mind as that could easily produce adverse effects in the markets, leading interest rates to new heights, making their position even worse.
- Because of their inability to make propositions, these two countries are trapped in a position where they cannot have any practical impact on political decisions and on the other hand must implement austerity measures that further worsen their economic situation by contracting their economy. Austerity needs to be implemented for the sake of showing compliance to the hard line of the surplus countries and for appeasing the markets, since inaction would be conceived as a sign of inability to deal with fiscal issues, again leading to uncertainty and unrest which would affect interest rates on sovereign bonds (see The ECB captivity and the Italian, Spanish and Belgian prisoners).
- Greece is treated in a way that causes excruciating pain to its society. The harsh treatment is used as a deterrent to any other country, sending a clear message that reforms must take place to avoid the suffering Greece is forced to endure. It is crystal clear that the demands of the ‘troika’ from Athens go against any economic reasoning and even though most can agree that reforms are more than necessary no sensible person would offer his consent to the sort of austerity policies the troika’s officials put forward. The malignancies of the Greek economy-society-state are deep seated and need to be addressed in their totality. Yet this must be done in a way that does not kill the patient.
All of the above form a quite complex situation, where it is by no means easy to allow the ECB to take the role it should always have. Whether the pressures coming from Italy (see A macroeconomic overview of the Italian crisis) will be enough to force policy-makers to change course of action, is a debate that everyone can speculate on. For now the ECB, with the stance it currently has, is in fact part of the problem, in the broader systemic crisis of the euro. In the end only radical measures will save the eurozone and its constituent economies from an apocalyptic implosion. However given the policy idiocy, that characterizes many of the proposals of the post-2008 era, no one can be sure that politicians will be able to act before it is too late.